A Hard Landing Down Under
By Andy Xie
Australia’s bubble is built on China’s, and with no major stimulus in the offing, it may suffer a financial crisis in 2013
Mining has been a boom-bust industry throughout its history. The reason is the long development process of a mining asset. When demand pushes up prices for minerals, supplies take time to respond. Hence, prices can go very high in the initial phase of a demand boom. The eye-popping profitability draws all kinds of people into speculating for new mines, massively increasing the supply capacity years down the road. When the demand boom cools and prices decline, supply capacity keeps rising rapidly, which throws the industry into a depression with severe repercussions for its financiers.
A decade ago, some Australian investors came to my office for advice on how to invest in China. I told them to go home and buy shares of Australian companies in the mining industry. Bellwether stocks like BHP have appreciated ten times since. The story began with China joining the WTO. This change would increase China’s share of global trade. As China’s expenditure is heavily weighed towards fixed-asset investment, this redistribution of income would increase the demand for mineral resources. Hence, I believed that the industry would have good times ahead.
As the prices of minerals like iron ore surged, the super profitability attracted all sorts of people into prospecting all over the world. Numerous investors went into African jungles and Mongolian grassland to strike it rich. Even though risks for investing there very high, like getting one’s head chopped off by upset locals, the fantastic margins pumped up these people’s courage. Unfortunately, if and when these assets become productive, the margins are gone. Most stories about chasing riches in faraway lands end like this. Some smart people have sold undeveloped assets to others through IPOs in Hong Kong. Those who haven’t sold are stuck.
‘There Are Such Opportunities’
The market went from not believing in China’s growth story a decade ago to extrapolating past performance into the infinite future. In particular, China’s massive stimulus in 2008-09 that revived demand for commodities amid a global downturn convinced investors or speculators in this industry not to worry, i.e., China could do the same again if there was another downturn. As demand has weakened and prices collapsed, the faith in demand and prices coming back is surprisingly strong. That is why so many marginal projects continue to seek funding.
The year 2008 should have been the end of this boom cycle. China’s stimulus misled the market into believing otherwise. China’s demand revival in 2009-10 was purely a governmental phenomenon. It piled more capacity formation on top of overcapacity. It merely postponed the inevitable adjustment and made it bigger. This is where the economy is now, paying for past mistakes. But the mining industry continues to believe and propagate the view that a big stimulus like in 2008 is coming.
I recently attended a mining investor conference in Sydney. Australia has a vibrant market for prospecting. Anyone with claim over some unexplored land could list as a penny stock. The initial fund-raising could finance drilling costs. If drilling doesn’t come up with anything, the stock price goes to zero. If samples show promise, the stock price surges. The company can then raise more money to fund further studies. When the evidence for a viable mine surfaces, the company is sold to one of the big mining companies like BHP or Rio Tinto. This market is very efficient at motivating exploration and spreading risks around. It fires up the dream of “striking it rich.”
In the conference, the story that got most attention was a penny stock just shot up 50 times in two months. The representatives from the company looked elated, proudly displaying shiny drilling samples. I met one lucky punter, a Chinese immigrant, who specializes in investing in such penny stocks. Through good research, he has picked more winners than losers. He recently spent millions of his winnings to buy a posh property close to the conference venue. “There are such opportunities in Australia,” he proudly told me.
Some mining assets under development are viable even in a downturn. For example, I heard of the development of an iron ore project with 50 million tons of annual production capacity. Such scale allows it to survive in a low price environment. Most projects, however, are not like that and couldn’t survive if the price keeps going lower. However, with so much investment in the ground already, investors are unwilling to walk away and hope for the market to recover. This dynamic is behind the mining investment bubble in Australia. When it bursts, its multiplier effects would force its economy into a hard landing.
Bubble on a Bubble
The Australian economy has boomed more than any other developed economy over the past decade. Its nominal GDP has doubled in a decade, and its currency value against the U.S. dollar has doubled too. As a result, its per capita income is much higher than in the United States or Europe. Its property is the most expensive among developed economies. The price of its main export, iron ore, appreciated ten times at its peak, which justified some of its prosperity. Foreign investment in its mining sector has played a more important role. It has caused the Australian dollar to appreciate strongly despite its current account deficit and higher inflation than elsewhere. The strong currency has attracted financial capital from retail investors in China and Japan. The snowball effect on the financial side has made the Australian economy strong despite the recent tumbling of the price of iron ore. As mentioned, the investment flow is sticky due to the long cycle of mining asset development.
So much capital inflow has pumped up Australia’s monetary system, creating an environment of easy credit. This is the factor behind the real estate and consumption booms. If capital inflow is a bubble, Australia’s property market must be a bubble, too. When the capital inflow reverses, the bubble will pop.
The Australian economy is probably a bubble on top of China’s overinvestment bubble. The latter’s unwinding will sooner or later trigger the former to do so, too. Among the mining investors I have met there is strong hope that China would soon introduce a stimulus like in 2008. This is why the price of iron ore has rebounded by 40 percent recently. Bottom fishers came in to speculate on China’s possible stimulus before or soon after the 18th Party Congress. They are likely to be disappointed. The last stimulus has made the overinvestment situation so severe that another round is just plain wrong. Also, it would trigger severe inflation and currency devaluation. I just don’t see it happening.
Any foreign capital-inspired asset bubble bursts when the flow reverses. It causes the monetary system to contract. As the central bank replaces the outflow with new money, the currency value drops, which frightens Asian retail investors who hold Australian dollar deposits. Their flight causes the currency to tank more and liquidity to tighten. The property market will fall with the tightening liquidity and capital flight, which frightens away more foreign capital in the property market. The new equilibrium is defined by a much lower currency value and property price. In this new equilibrium, the currency value could be half of its peak value.
The trigger will likely be a series of mining projects failing to obtain financing in the international capital market. Their investors will have to walk away from their investments. The reduced capital inflow makes the current account deficit more difficult to finance. Of course, a lower iron ore price increases the deficit too. The combination will cause the currency to establish a declining trend. The trend will send other financial capital to flee.
Judging the timing of a bubble bursting is always an art. My gut feeling is that it happens in 2013. The global economy is sinking. This big picture makes the financing market jittery. When China’s stimulus fails to materialize in six months, many mining investors would walk.
The Multiplier Effect
On the way up a bubble has many ways to snowball. The same is true on the way down. When a currency is appreciating, there is strong demand for property. The strong property market powers credit-financed consumption. Australia has a highly developed capital market like in the United States. The multiplier effect is powerful on the way up. Debt has piled up in every corner of the economy, and creative accounting is employed to pump up banks’ balance sheets. One consequence is that Australia has the highest net foreign debt among all developed economies.
On the way down people realize that they cannot spend borrowed money forever, and the assets on banks’ books are not worth as much as they say. What happened to the United States in 2008 could happen to Australia in 2013. Australia may suffer a full-blown financial crisis.
We Never Learn
Karl Marx said that history repeats itself, first as tragedy, then as a farce. Asset bubbles repeat themselves again and again, mocking mankind. People are so capable of suspending logic and believing in easy money, having a good time at no cost, and getting rich quick. When it all blows up, they blame somebody else, like the central bank for raising interest rates, government’s for tightening, short sellers, or somebody’s bad mouthing. They then ask for help, bailouts, or other assistance, even if they believe that the help would make things even worse eventually. The same will happen when Australia’s bubble bursts.
This dynamic is now unfolding in China. Numerous speculators are stuck in property. Few people in China believe that another round of stimulus would do the country any good. But they still hope for another round because it could help them to unload their unsold properties or earn some quick money to pay off loan sharks. It feels painful now that some relief is desirable even if it kills you afterwards. But for everyone to unload, some stimulus must happen.
Stimulus, when used repeatedly, loses its effectiveness because everyone wants to exit as soon as possible. The current round of monetary stimulus is only a month old. It is already losing traction. The global economy is sinking again. The odds are that the global economy is either near or in another recession already.
When stimulus completely loses its effectiveness and just spews out bad stuff like inflation, people stop wanting it. Ben Bernanke tries to use stimulus to cover up the messes left behind by Alan Greenspan. When it completely stops working, someone like Paul Volcker will appear, telling people to suck it up. That day is not far away.
The author is a board member of Rosetta Stone Capital Ltd.